The family limited partnership has had its proponents and opponents over the past several years. A new taxpayer victory out of the Fifth Circuit will only fuel the debate over whether one camp or the other is right.
A snapshot of the current state of case law and Internal Revenue Service attitudes on FLPs, however, can help put current planning in perspective. While the latest case scores a significant victory for the use of FLPs, our conclusion is that a conservative approach to FLPs continues to work best.
Definition and uses
A family limited partnership is typically created to hold appreciating business or investment properties, the limited interests in which usually qualify for substantial valuation discounts. An FLP is usually funded largely by senior generation family members who are the general partners. Limited partnership units are subsequently transferred to junior generation family members.
In exchange for the assets, the transferor usually receives a very small general partnership interest (e.g. 1 percent or 2 percent) and a large limited partnership interest. The transferor retains the general interest and transfers a portion of the limited interest to the younger family members. The interests received by the children are usually minority interests. The general interest allows the transferor control over the operation of the business despite that interest representing only a small percentage of the business’s value.
Retention of too much control by the older generation, however, can be fatal to the plan. Recently, the IRS has seized upon the “control” issue and has made it the focal point of FLP litigation.
The bad news
First, the bad news. Code Sec. 2036(a) has become the IRS’s weapon of choice against FLPs, as it has all but abandoned arguing against deep discounts as a first line of defense. The IRS has won several cases recently under Code Sec. 2036(a). At the heart of its victories is the argument that the taxpayer has not respected the underlying entity, which in turn allows the FLP to be disregarded at the death of the older-generation “transferor.”
Under Code Sec. 2036(a), the value of the gross estate includes the value of all property, including any interest the decedent has transferred. Two exceptions are made to this rule that otherwise pulls back transferred property for inclusion in the gross estate. First, if the transfer is a bona fide sale for full and adequate consideration, Code Sec. 2036(a) does not apply.
Second, even if there is no bona fide sale, the transfer still may be excluded if the decedent did not retain possession, enjoyment or rights to the property, or the right to designate the persons who would possess or enjoy the asset.
In Strangi Est., T.C. Memo. 2003-145, the facts and circumstances supported the conclusion that an implied agreement existed:
- The decedent transferred nearly all his wealth to the entities, leaving him with few liquid assets for living expenses;
- The decedent continued to occupy his home after it was transferred to the FLP, where accrued rent was not paid for over two years;
- The entity funds were used to pay for the needs of the decedent and his estate; and,
- The arrangement resembled an estate plan more than a joint enterprise and did not change substantively the decedent’s relationship to the transferred assets.
The court further determined that, for the purposes of Code Sec. 2036(a), no bona fide sale occurred in connection with the transfer of property to the entities involved because the decedent essentially stood on both sides of the transaction.In I. Abraham Est., TC Memo. 2004-39, the court determined that the documentary evidence, trial testimony, and the understanding of the decedent’s children and legal representatives established that the decedent was entitled to all of the income earned by the FLP required to meet her needs. As a result, the court held that the decedent retained the enjoyment and use of the transferred FLP interests and, therefore, the entire value of those interests was includible in her gross estate under Code Sec. 2036.
In L. Hillgren Est., TC Memo. 2004-46, the court concluded that a limited partnership created by the decedent and her brother was to be disregarded for estate tax purposes because the decedent retained the right to enjoy and use the seven parcels of property she transferred to the partnership.
The decedent’s interests in and management responsibilities for these properties were not altered by the formation of the partnership. She received disproportionate distributions from the partnership to cover her living expenses and her brother did not contribute property. The court concluded that the partnership was an alternate testamentary vehicle.
Finally, some good news
The good news on the FLP front comes in the form of two recent cases. The latter of these cases is being considered a major defeat for the IRS.
Stone. In E. Stone III Est., TC Memo. 2003-309, the Tax Court found that Code Sec. 2036 did not apply to transfers of assets by the decedents to five FLPs; rather, the transfers fell within the bona fide sale exception. In an effort to resolve litigation among the decedents’ children, the decedents created these FLPs and, according to the court, this demonstrated a strong non-tax motive for their creation. In addition, the court concluded that the decedents were motivated by investment and business concerns relating to the management of their assets and the FLPs had economic substance as joint enterprises for profit. And, in contrast to Strangi, the decedents in this case retained sufficient assets to maintain their accustomed standard of living.
Kimbell. In Kimbell, CA-5, May 20, 1994, the IRS was soundly turned back in its use of Code Sec. 2036(a). Before her death at age 96, the decedent transferred a large part of her estate to three entities: a revocable trust, a limited liability company, and a limited partnership. She and her son (who was also executor) were co-trustees of the trust. The son and his wife formed the LLC. The trust contributed $20,000 for a 50 percent interest in the LLC; the son and his wife both contributed $10,000 for 25 percent interests each. The trust and the LLC later formed the FLP. The trust contributed $2.5 million in cash, oil and gas interests, securities, notes and other assets for a 99 percent limited interest. The LLC contributed $25,000 in cash for a 1 percent general partnership interest.
The estate claimed a 49 percent discount on the value of the decedent’s interests in the FLP and the LLC for lack of control and marketability of the partnership interest. The IRS, however, determined that all of the $2.5 million in trust assets must be included in the gross estate under Code Sec. 2036(a).
The district court ruled in the IRS’s favor. Because the decedent and family members were present on both sides of the transfer to the partnership, the district court found that the transfer was not at arm’s length and, therefore, not a “bona fide sale.” The district court also found that the decedent did not receive adequate consideration for the assets she transferred to the partnership. The district court viewed the transaction as a mere “recycling of value.”
The Fifth Circuit reversed.
It ruled that the transfer of assets to the partnership was a bona fide sale for adequate and full consideration, thus qualifying under the Code Sec. 2036(a) exception. The decedent received a partnership interest that was proportionate to the assets she contributed. The assets contributed by each partner were properly credited to the partners’ capital accounts. On termination or dissolution of the partnership, the partners were entitled to distributions according to their capital accounts.
Moreover, the decedent retained sufficient assets outside the FLP for her own support and did not commingle FLP and personal assets; partnership formalities were satisfied and the contributed assets were actually assigned to the FLP; and there were credible non-tax business reasons for the FLP’s formation. The fact that the decedent’s estate claimed a 49 percent discount in valuing the decedent’s interest did not preclude a finding that the interest was adequate consideration for the assets transferred.
Further, the Fifth Circuit refused to approve the per se rule followed by the lower court that would prevent related parties from entering into an arm’s-length transaction for adequate and full consideration.
In matters such as an FLP in which substantial assets are at stake, a conservative approach is generally favored. For an FLP, this means not concluding that Kimbell has given taxpayers the green light on almost any variety of FLP arrangement. It also means not taking IRS victories as a stop sign.
Both the recent taxpayer wins and losses point to certain steps that should be taken in using an FLP. With these measures, however, designed to make conservative savings on transfer taxes, use of the FLP appears “alive and well,” at least while the estate tax continues to be part of the future. The steps that should be taken include:
- Set up the entities while the older generation is still healthy;
- Only include business assets (Congress is considering a bill that would do just that);
- Limit or eliminate legally enforceable donor controls of partnership assets;
- Persuade the donor, where practicable, to relinquish any interest income in the FLP prior to death;
- Leave the donor with adequate assets to cover all living expenses;
- Conduct legitimate negotiations between the older and younger generations concerning the funding and operation of the FLP;
- Limit the donor’s management responsibilities; and,
- Respect the partnership.
George G. Jones, JD, LL.M, is managing editor, Federal and State Tax, and Mark A. Luscombe, JD, LL.M., CPA, is principal analyst, Tax & Accounting, at CCH Inc.
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